Sunday 28 August 2016

What Moving Averages Can Teach Us About O&G Stocks

I am not a person who uses technical analysis in analysing stocks. Even then, I found the concept of moving averages (MAs) to be very useful in understanding Oil & Gas (O&G) stocks and developing investment strategies for them. The figure below shows a typical MA chart with several MA curves using Brent crude oil price as the basis. As we all know, when the spot price moves down, the shortest duration MA curve will move down first, before the longer duration MA curves follow suit. Conversely, when the spot price moves up, the shortest duration MA will move up first, followed by longer duration MA curves.

Oil Price and Its Moving Averages

We can assign O&G companies in different O&G sub-sectors to different MA curves. Exploration & Production (E&P) companies like KrisEnergy, which drill oil and sell in forward contracts of several months ahead, can be assigned to, say, the 2-month MA. Offshore Support Vessel (OSV) companies like EMAS Offshore, which lease OSVs to drilling contractors for charters of several years, can be assigned to, say, the 2-year MA. Ship/rig building companies like Keppel Corp, which take 2 years to build a ship and 4 years to build a rig, can be assigned to, say, the 3-year MA.

Thus, from the MA chart above, we can see that oil price has bottomed out in Jan 2016. The 2-month MA has also bottomed out not long after. This indicates that E&P companies, as represented by the 2-month MA, have started to benefit from the higher oil price. In contrast, both the 2-year and 3-year MAs are still declining. OSV companies and ship/rig building companies are still on the down trend. Moreover, comparing between the 2-year and 3-year MAs, the 2-year MA is currently lower and declining faster than the 3-year MA, indicating that OSV companies are in a worse shape than ship/rig building companies at this moment in time.

When oil price is just starting to decline, it is usually best to stick to companies on the longest duration MA as the economic impact on earnings would not be apparent until several quarters later. As an example, even though oil price has started to fall significantly since Jun 2014, concerns on Keppel Corp's earnings received maximum attention only in Jan 2016 when Sete Brasil shareholders discussed plans to file for bankruptcy. 

However, when oil price begins to bottom out, it is not a bad idea to switch to companies on the shortest duration MA as the economic impact on earnings will show up there first. Longer duration MAs will still continue to fall. As an example, Interra Resources, an E&P company, reported a 34% increase in revenue in its 2Q2016 results over 1Q2016, despite seeing a 6% drop in oil production volume over the same period. In contrast, Keppel Corp saw a 12% decline in revenue and 36% decline in net profit in its Offshore & Marine (O&M) segment over the same period. Its earnings are expected to worsen in the next 2 years.

Thus, MAs provide a useful model for understanding the economics of O&G companies in various sub-sectors. However, there are several major limitations of this model. Firstly, MAs do not represent the true economic conditions of companies. Oil price will never go down to zero. Neither will MAs that track oil price. However, O&G companies can have negative earnings and become bankrupt. We have already seen several of them entering judicial management. Secondly, MA is only a technical indicator. To understand a company fully, you still need to carry out fundamental analysis. As an example, even though the revenue of E&P companies are looking up, there are significant challenges confronting individual E&P companies as explained in My Upstream Oil & Gas Rescue Operations. Likewise, even though the earnings of Keppel Corp's O&M segment are looking down, there are silver linings as discussed in Keppel Corp – A Good Captain Sailing Through Rough Waters. Thirdly, given the significant oversupply in OSVs and oil rigs, it might take longer than 2 to 3 years before the earnings of OSV and ship/rig building companies recover. In other words, it might be a 2- to 3-year MA on the way down but 4- to 6-year MA on the way up.

MAs are a useful model in understanding the economics of O&G companies and developing suitable investment strategies for them, but it is important to understand the limitations and use with care.

P.S. I am vested in Keppel Corp, KrisEnergy and Interra Resources.

Sunday 21 August 2016

My Downstream Oil & Gas Recovery Operations

Last week, I blogged about My Upstream Oil & Gas (O&G) Rescue Operations. This week, the focus is on my downstream O&G stocks. Upstream O&G refers to the exploration and production of crude oil, while downstream O&G refers to the processing of crude oil into refined oil products such as gasoline. If you refer to the profit contributions at oil majors such as Exxon Mobil, BP, Shell, etc., downstream operations have been the segment that is making up for depressed profits at upstream operations. The figure below shows the breakdown of profits from upstream and downstream operations for BP (source: Bloomberg).

Fig. 1: Profits from Upstream & Downstream Operations for BP

The fact that downstream operations are making more money than before the oil crash is not surprising. Refineries buy crude oil and sell refined oil products. Given the prolonged crash in crude oil price since mid 2014, their input price has dropped and refining margins have increased. However, the increased refining margins are only temporary, eventually, the glut in crude oil volume will find its way to the refined oil product market and depress the selling price of refined oil products, thereby diminishing the refining margins. Fig. 2 below shows the diminishing refining margins (source: Bloomberg).

Fig. 2: Refining Margins

Still, downstream O&G is comparatively more stable than upstream O&G. In Singapore, we do not have any listed companies that operate refineries. However, we have a couple of companies that build and maintain petrochemical plants, storage tanks, oil terminals, etc. Some of these Engineering, Procurement and Construction (EPC) companies include Rotary, PEC, Hiap Seng, Hai Leck and Mun Siong. 

Generally, compared to upstream companies, the business of these EPC companies are much more stable, because the more OPEC countries pump oil to increase market share, the more oil that needs to be transported, processed and stored. However, some of the customers in this segment are the oil majors which are cutting costs wherever possible. There is also increased competition for less new EPC projects, thereby depressing margins for these companies. Nevertheless, downstream companies have performed better than upstream companies at withstanding unexpected shocks. When Swiber announced winding-up in Jul, Pacific Radiance announced that it had to provide for about $13.5M (USD10.1M) in doubtful receivables, which led to a sustained sell-off in its shares (together with other upstream O&G stocks). In contrast, in Oct last year, PEC had to write-off trade receivables of about $19M when Jurong Aromatics went into receivership. Its share price held steady after the news.

Among the listed companies mentioned above, PEC has ventured into Middle East and increased its revenue. It essentially points the way to what companies can do to survive the long and harsh O&G winter: go into Middle East where oil production is increasing at the expense of everywhere else and have a large portion of revenue from maintenance projects. Even if companies stop buying/ building new facilities, they still have to maintain their existing ones. In FY2015, Middle East contributed 18% of total revenue by geography while maintenance contributed 31% of total revenue by segment. Action-wise, at the middle of last year, my original cost price in PEC was $0.59. After its announcement of Jurong Aromatics going into receivership in Oct 2015, I averaged down at $0.375.

Rotary operates in a similar size and geography as PEC. However, it relies predominantly on projects rather than maintenance. The proportion of revenue from maintenance is only 17% in FY2015. Due to a lack of new projects, its revenue in FY2015 fell by 52%. Middle East contributed 30% of total revenue. As the business prospects are uncertain, I have not averaged down. My cost price remains at $0.62.

Hiap Seng is smaller than both Rotary and PEC and operates predominantly in South East Asia. In FY2016, it swung from a loss of $12.7M to a profit of $5.6M. When oil was trading at below USD30 in Jan, I initiated a small position at $0.10 as a turnaround play.

Hai Leck is even smaller and operates in Singapore only. It derives 67% of its revenue from maintenance in FY2015. What attracted me to it initially was its high dividend. It paid interim dividend of $0.05 in Jun. I initiated my position in Jun/Jul at an average price of $0.38, hoping for more dividends to come.

Mun Siong is the smallest of all the companies mentioned above and operates in Singapore only. I decided to give it a miss, although it also pays fairly good dividends. 

Finally, there is an oil trader in China Aviation Oil (CAO). Like all other upstream O&G companies, its revenue and share price crashed in 2015. I was concerned initially, but eventually accepted the explanation that Noble gave, which is that it is a commodity trader and is not affected by the commodity price. CAO was identified as 1 of the 2 O&G stocks in my portfolio that could save itself and others. However, there was a problem: I had maxed out the position limit on this stock. Thus, when the share price recovered to my cost price of $0.86 in Apr, I sold about half my position, hoping to create some space to buy should it decline subsequently. It went up instead and there went a part of my O&G rescue plans. (Note: Given the significant run-up in price, CAO is now considered as available-for-sale.)


Although all are in the O&G industry, the prospects of upstream and downstream O&G companies could not have been more different. Upstream companies are facing the most significant challenges seen in decades, with no signs of letting up yet. In contrast, downstream companies are comparatively more stable, although profits are nothing to shout about. 

Some investors, like myself, like the excitement of finding multi-baggers, and the O&G industry presents opportunities as well as significant risks. However, as explained in Different Types of Bears, upstream companies are facing a ferocious bear. When faced with such a bear, it is not good enough just to have sufficient endurance, i.e. buy and hold for as long as it takes to outlast the bear. Not all companies will survive and we have already seen a couple of companies falling by the sideways. More are expected to come. Make one mistake and it would be difficult to recover.

On the other hand, downstream companies are facing the long-winded bear which is milder. Given sufficient endurance, it is usually possible to outlast it. This is why the plans for the downstream O&G stocks are considered as recovery operations (i.e. average down and hold) but that for the upstream O&G stocks are rescue operations (i.e. average down and sell)!

Finally, O&G is highly risky. I would not recommend it to anybody. Like what BullyTheBear said, it is not as if there is only this sector to focus on!

Just a disclaimer, this post is not a recommendation for anyone to buy or sell any O&G stocks. It is a recollection of my actions to rescue the downstream O&G stocks in my portfolio.

See related blog posts:

Sunday 14 August 2016

My Upstream Oil & Gas Rescue Operations

If you have been following my blog in recent months, you would know that I have been blogging about the Oil & Gas (O&G) industry, starting with oil and moving down the industry value chain to Exploration & Production (E&P), Offshore Support Vessel (OSV) and finally ship/rig building sectors. It is time to string everything together to discuss my rescue operations for the upstream O&G stocks that I have carried out since the start of this year. Please note that the rescue operations were formulated before the Brexit referendum and Swiber's application for judicial management. Post-Brexit and post-Swiber, I am not so sure I can pull off these rescue operations.


As explained in The Demand and Supply for Oil, there is an inflexion point at around USD35, below which the supply for oil becomes elastic and oil price becomes more resistant to further falls. At this level, it is only a matter of time before oil price recovers. Furthermore, unlike companies operating in the O&G industry, oil price will never go down to zero and be bankrupt. Thus, an Exchange Traded Fund (ETF) that tracks oil price is one of the safer investments in the O&G industry. You just have to wait very patiently for the recovery in oil price.

There is only 1 ETF listed on the Singapore Exchange that tracks oil price, but it is not a pure oil play. Besides oil, it also tracks other commodity prices such as gold, industrial metals and grains. The ETF is Lyxor Commodities, which has a 31% exposure to oil price and 6% exposure to gas price. 

Thus, when oil price was languishing around USD30 in end Jan, I bought Lyxor Comm at USD1.55 and brought my average price down to USD2.20.

Exploration & Production Companies

As discussed in The Missing Link Between Oil Price & O&G Profitability, only companies that are involved in oil exploration and production have a direct relationship with oil price. These E&P companies produce and sell oil in the market. Any change in oil price has a direct impact on their profitability. Thus, when oil price recovers, E&P companies will stand to gain.

Nevertheless, there are also significant risks for E&P companies. The exploration part of the business is high-risk and high capex, not unlike buying a lottery ticket. You can never be sure that the oil field purchased will be able to produce sufficient quantity of oil to be commercially viable. When an oil field is found to be commercially viable, the company will then have to spend more money to develop the oil field for commercial production. Given the uncertainty in oil price, spending money to explore and develop oil fields are risky decisions. 

There are a couple of mostly small E&P companies listed on SGX. My picks in this sector were Kris Energy, Interra Resources and Ramba Energy. Each company has its own dynamics and challenges. Ramba Energy has not produced a single drop of oil yet but plans to do so later this year. It also plans to issue a rights issue soon. Interra Resources is on the other end of the spectrum. It is already producing oil, but oil is a depleting resource. Without incurring money to explore and develop new oil fields, its oil production will continue to decline. Kris Energy is the biggest E&P companies listed on SGX. It has a pipeline of both production and exploration oil fields. Unfortunately, it also has SGD330M of outstanding bonds that will mature in 2017 and 2018.

Thus, even though E&P companies will stand to gain from a recovery in oil price, they are not without risks. Linc Energy, for example, has gone into voluntary administration. My investments in these companies are purely speculative and involved only a small amount of money.

Oil Services and OSV Companies

Among the various sectors in the O&G industry, oil services and OSV sectors are probably among the worst hit currently. We have Technics Oil & Gas and Swiber going into judicial management. As explained in The Missing Link Between Oil Price & O&G Profitability, the primary reason they are not doing well is because they rely on oil majors for their business. In their attempt to navigate the deep and prolonged slump in oil price since Jun 2014, oil majors have cut E&P spending budgets, jobs and deferred major projects. In my opinion, even if oil price were to recover to higher levels, oil majors will be very cautious in raising spending budgets to previous levels after going through such a difficult period. For more information on OSV companies, you can refer to Lessons for Investing in OSV Companies from Shipping Trusts.

These are the sectors to avoid for now. My worst O&G stock (MTQ) is from the oil services sector. The average price for MTQ is $1.34 and I have maxed out the position limit for this stock. I can only ignore it for now. The consolation is that its debt/equity ratio is still manageable at 44%. 

Ship/Rig Building Companies

The ship/rig building sector is further downstream of the OSV sector. It is also facing declining business, but as explained in Keppel Corp – A Good Captain Sailing Through Rough Waters, we have not seen the worst in this sector yet, which explains why shipbuilders seem to perform better than oil services and OSV companies for now.

Having said the above, the actions that individual companies take can help to mitigate the impact to some extent. For more information on Keppel Corp's mitigation actions, you can refer to the above-mentioned post and How Will Keppel Corp Navigate the Oil Crash?

Action-wise, at the start of the year, my cost price for Keppel Corp was $6.83. Not only that, I also had the stock in my joint account with my father. When Keppel Corp crashed to below $5 in Jan, I decided to take over the stock in the joint account, which meant I faced double the loss. This left me with no choice but to execute a risky averaging down action which brought my average price down to $6.08. Thankfully, when Keppel Corp recovered to above that price in Mar, I quickly sold 70% of it. I hesitated to sell the remaining 30%, because I knew among all the O&G stocks in my portfolio, Keppel Corp was probably 1 out of only 2 stocks that could save itself and others. When I finally concluded that I should sell all of it, it had already dropped below my average price. Anyway, as explained in Keppel Corp – A Good Captain Sailing Through Rough Waters, keeping it might not be too bad a choice, except that it might probably take 5 years or more to recover.

The other shipbuilding stock in my portfolio is Baker Tech. My original cost price was $1.25 and I averaged down at around $0.875 in Jan and Mar in anticipation of the recovery in oil price. Unfortunately, I forgot that it planned to carry out a share consolidation and most companies that do so end up having lower prices post-consolidation. It does not have much shipbuilding business, so it gave itself an order to build a liftboat. It currently trades at $0.555, but has $0.558 in cash and no debt as at end Jun 2016. Having said that, the cash reserves will continue to drop as construction of the liftboat progresses. Given its large cash reserves, it should be able to survive the harsh O&G winter.


This has been a long post. To summarise my rescue strategy for the upstream O&G stocks, I am relying on oil price to recover. Direct beneficiaries of this will be ETFs that track oil price and E&P companies that sell oil. I am also relying on the market failing to understand The Missing Link Between Oil Price & O&G Profitability, so that all O&G stocks will rise when oil price rises. However, post-Brexit, oil price has retreated back to USD40 from USD50. Post-Swiber, the market has also realised that some O&G companies have significant challenges in surviving the long and harsh winter. Time is running out in these rescue operations.

Just a disclaimer, this post is not a recommendation for anyone to buy or sell the above-mentioned or any O&G stocks. It is a recollection of my actions to rescue the upstream O&G stocks in my portfolio.

See related blog posts:

Sunday 7 August 2016

Is Keppel Corp's Provision for Sete Brasil's Orders Adequate?

When both Keppel Corp and SembCorp Marine announced their financial results for FY2015 earlier this year, they made provisions of $230M and $329M for Sete Brasil's orders respectively. SembMar's provision is 43% higher than Keppel Corp's, even though SembMar's orders ($7.0B) are only 13% higher than Keppel Corp's ($6.2B). The big question is whether Keppel Corp's provision for Sete Brasil's orders is adequate and whether further provisions are likely in future quarters. 

I have not attempted to answer this question earlier, mainly because it requires a lot of information to do so. Furthermore, the margin of error is large due to the imprecise nature of the information. Compared to the total contract value of $6.2B, a rounding error of $0.1B is only a 1.6% error, however, it can mean $100M in provisions! Thus, I can only hope to be generally right rather than precisely right in this post.

In the 2Q2016 financial results released 2 weeks ago, Keppel Corp has reiterated that its provision of $230M is adequate. It also, for the first time in its financial results, disclosed that its outstanding order book for Sete Brasil's orders is about $4.0B, rather than the $3.7B estimated in my earlier post on How Will Keppel Corp Navigate the Oil Crash? With this additional piece of information, there is better clarity on whether the Sete Brasil's provision is adequate.

The total contract value of Sete Brasil's orders is $6.2B. After deducting the outstanding contract value of $4.0B, Keppel Corp has carried out works worth $2.2B. In the briefing on FY2015 financial results, Keppel Corp disclosed that $1.8B (the Q&A mentioned $1.3B, likely to be in US dollars. You can download the Q&A here.) has been collected from Sete Brasil prior to it stopping progress payment in Nov 2014. This leaves it with a contract value of $0.4B for which work has been carried out but payment not collected yet. There is a need to understand whether this $0.4B of contract value appears in the balance sheet as Work-in-Progress, for which profits have not been booked and therefore requires lower provisions, or trade receivables, for which profits have been booked and need to be reversed out. Assuming the worst case scenario that it is a trade receivable, the full $0.4B needs to be provided for. Keppel Corp has made provisions for $0.23B, which leaves another $0.17B of potential provisions. Note that this figure assumes that Keppel Corp's liabilities to its suppliers have been fully accounted for, because it is possible for Keppel Corp to receive materials from suppliers but not carry out work using these materials yet. Keppel Corp will have to pay suppliers even if no work has been carried out using them. If this has not been accounted for, the potential provisions will increase further.

The above additional provision of $0.17B assumes that no further work is carried out on the Sete Brasil rigs. It is possible that Keppel Corp will complete some of the rigs already in advanced stages of completion and sell them in the open market. However, given the depressed market for rigs, Keppel Corp might not fetch a good price for the completed rigs. If the selling price is lower than the cost to complete them, further losses are likely. Let us examine this scenario.

The rate of completion for the 6 rigs is estimated to be 92%, 70%, 40%, 21% and less than 10% each for the remaining 2 rigs (see Sete Brasil is not the only thing Keppel needs to worry about, say analysts). Let us assume that Keppel Corp will complete the first 4 rigs. Assuming the price of each of the 6 rigs is the same, the total contract value will be $4.1B. In FY2014, when times were good, Keppel Corp could generate an operating margin of 14%. That means the profit from these 4 rigs is $0.6B and the cost to complete them is $3.5B (For now, please ignore the fact that the rigs are partially completed and there is no need to spend the full $3.5B to complete the rigs). I do not know how much the rigs will fetch in the open market. Let us assume they can fetch only 70% of the original contract price of $4.1B, or $2.9B, which means Keppel Corp will lose $0.6B on these rigs.

In a normal transaction, if a buyer and a seller agree to a price of $100 for a goods, but the buyer could not fork out the money and the seller could only resell it at $80 in the open market, the buyer is still liable to the seller for the shortfall of $20. Depending on what are the terms of the contracts with Sete Brasil, Keppel Corp might have remedies to get Sete Brasil to top up the $1.2B difference between the market price of $2.9B and the contract price of $4.1B. However, Sete Brasil has now gone into backruptcy protection and cannot fork out the money. Thankfully, Keppel Corp has collected $1.8B in progress payments from Sete Brasil for the 6 rigs. That will be used to top up the difference. Thus, no further provisions are required when the rigs are sold. In fact, the previous provision of $230M could be written back and Keppel Corp could book a profit on the rigs. Just take note that it will be a fairly long time before the market for oil rigs can recover and Keppel Corp can sell the rigs.

In conclusion, Keppel Corp's provision of $230M for Sete Brasil's orders is generally adequate for now. Further provisions are possible, but the provisions can be written back when the market recovers and the rigs are sold.

See related blog posts: